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3M (NYSE:MMM) reported a fine 3rd quarter, but shares were hammered downward by about $5, in part because of cautionary comments about pension headwinds (.30) for 2011. In evaluating postretirement benefit obligations the company anticipates that a key assumption, the discount rate, will decline by approximately 1 percentage point.

This issue has been mentioned on other company's conference calls, and may become a greater concern at year end. Honeywell (NYSE:HON) sees the same 1 percent decrease. Briefly, a decrease in the discount rate results in an increase in the obligation. This sensitivity to low rates is exacerbating shortfalls created by the difficult investment climate during the financial crisis. While GAAP accounting permits the shortfalls to bypass the income statement and hide out on the balance sheet in AOCI (accumulated other comprehensive income) for protracted periods, they must be dealt with. Unless investment results overcome the shortfalls, they must eventually be passed through the income statement, reducing reported profits.

The company was showered with a deluge of downward target adjustments, mostly in the 5 range.

Sensitivity

The sensitivity of a company's postretirement benefit obligation to changes in the discount rate is normally presented on the 10-K in dollars per .25% change. In MMM's case, they present only the effect on the current years pension expense, which is not the same information. However, by using ratios on other companies disclosures, I estimate that each .25% increase in MMM's discount rate will increase the obligation by 2%. A 1% decrease in discount rate approximates an 8% increase in the benefit obligation, in MMM's case, working off the 2009 10-K, this amounts to 17.655 billion X 8% = 1.412 billion divide by 711 million shares outstanding = 1.98 per share.

Reversible

The discount rate is at historic lows. Presumably over time it will revert to more normal levels. When this occurs, the above charges will reverse out of AOCI and may never make the income statement in full. This is essentially a mark to market issue. The benefit obligation is marked up due to market conditions, and can be marked down when conditions change.

Pension Performance and Assumptions

Here is some information from MMM's 10-K which I find reassuring:

For the U.S. qualified pension plans, the Company’s assumption for the expected return on plan assets was 8.50% in 2009. Projected returns are based primarily on broad, publicly traded equity and fixed-income indices and forward-looking estimates of active portfolio and investment management. As of December 31, 2009, the Company’s 2010 expected long-term rate of return on U.S. plan assets is based on an asset allocation assumption of 40% global equities, with an expected long-term rate of return of 8.7%, 13% private equities with an expected long-term rate of return of 12.7%; 26% fixed-income securities with an expected long-term rate of return of 4.6%; 16% absolute return investments independent of traditional performance benchmarks, with an expected long term return of 6.5%; and 5% commodities with an expected long-term rate of return of 6.4%. The Company expects additional positive return from active investment management. These assumptions result in an 8.50% expected rate of return on an annualized basis in 2010. The actual rate of return on plan assets in 2009 was 12.6%. In 2008 the plan experienced a loss of 13.6% and in 2007 earned a rate of return in excess of 14%. The average annual actual return on the plan assets over the past 10 and 25 years has been 5.6% and 11.2%, respectively. Return on assets assumptions for international pension and other post-retirement benefit plans are calculated on a plan-by-plan basis using plan asset allocations and expected long-term rate of return assumptions.

The point here is that MMM has a fine long term history of investment performance on their pension plan assets, and most notably they avoided a big hit 2008, with a loss of only 13.6%. Also, they traversed the lost decade with a gain of 5.6%, not bad under the circumstances. Expecting these superior returns to persist, I anticipate that MMM will avoid serious difficulties with their pension obligations.

Summary

The effect of the expected change in pension assumptions is most likely temporary, and if permanent can be quantified at 2.00 per share. MMM has a history of strong performance in their handling of their pension fund asset investments. The markets sudden downward revision of 5 is excessive.

Options Strategy

A vertical call spread along the following lines makes sense to me, given my opinions on the over-reaction incorporated in recent price changes:

Buy to open 10 MMM Nov 20 2010 80.0 call @ 4.72
Sell to open 10 MMM Nov 20 2010 85.0 call @ 1.38

Net debit of 3.32, with shares trading a bit over 84 at the time of the trade. The trade breaks even if shares are at 83.32 at expiration, and earns 1.68 if shares close above 85 at expiration. Basically, this is a bet on a short term recovery from market over-reaction.

Disclosure: Long MMM, no position HON

Source: Reaction to 3M's Pension Headwinds Is Overdone